Interpreting Changes in the Forward Premium
Response to the following problem:
Assume that interest rate parity holds. At the beginning of the month, the spot rate of the Canadian dollar is $.70, while the 1-year forward rate is $.68. Assume that U.S. interest rates increase steadily over the month. At the end of the month, the 1-year forward rate is higher than it was at the beginning of the month. Yet, the 1-year forward discount is larger (the 1-year premium is more negative) at the end of the month than it was at the beginning of the month. Explain how the relationship between the U.S. interest rate and the Canadian interest rate changed from the beginning of the month until the end of the month.